The shareholder wealth maximization myth

In a recent speech at the Netroots Nation, Senator Al Franken tried to frighten the crowd by trotting out the corporate bogeyman that greedily makes decisions without regard to anything other than profit. Franken told them: “it is literally malfeasance for a corporation not to do everything it legally can to maximize its profits.” Individuals across the political spectrum share this common canard. Those on the right, like Milton Friedman, argue that the shareholder-wealth-maximization requirement prohibits firms from acting in ways that benefit, say, local communities or the environment, at the expense of the bottom line. Those on the left, like Franken, argue that the duty to shareholders makes corporations untrustworthy and dangerous. They are both wrong.

While the duty to maximize shareholder value may be a useful shorthand for a corporate manager to think about how to act on a day to day basis, this is not legally required or enforceable. The only constraint on board decision making is a pair of duties – the “duty of care” and the “duty of loyalty.” The duty of care requires boards to be well informed and to make deliberate decisions after careful consideration of the issues. Importantly, board members are entitled to rely on experts and corporate officers for their information, can easily comply with duty of care obligations by spending shareholder money on lawyers and process, and, in any event, are routinely indemnified against damages for any breaches of this duty. The duty of loyalty self evidently requires board members to put the interests of the corporation ahead of their own personal interest.

Under this legal regime, it is not malfeasance for boards or corporate chiefs to make decisions that do not maximize shareholder value. Boards are protected by the so-called “business judgment rule” from claims that their decisions were the wrong ones. The business judgment rule protects corporate decisions unless the plaintiffs can show a breach of one of the two duties. In other words, unless there is a plausible story the board’s decision was woefully uninformed or was tainted by self interest, a shareholder challenge to a corporate decision will fail.

The business judgment rule means that decisions that turn out badly for firms are protected. This encourages risk taking and avoids the hindsight bias of litigation in cases where well-meaning and rational decisions do not maximize shareholder value. It also gives boards wiggle room to take more than just profit into consideration when setting corporate policy. As such, firms can tailor their decisions to the demands of the marketplace. One company might believe that employees, customers, and shareholders (the three big constituencies of any firm) prefer a decision to keep open a more expensive factory in Michigan, while another company might believe these stakeholders prefer a decision to move its manufacturing base to Mexico. Both are lawful.

The law lets a thousand flowers bloom, trusting in the markets for labor, products, and investments to determine which of these is optimal for all the individuals involved. A shareholder suit challenging the decision about whether to move the factory would surely lose, even if the decision turns out to be a disastrous one. The shareholder’s alternative to suing is to sell their shares, what is known as the “Wall Street Rule.” This alternative to legal enforcement means there should be innumerable different types of firms catering to the different preferences that exist in the country for work, products, and investments.

To have any other rule would invite costly and inefficient judicial second guessing of business decisions. This would be bad for firms that are trying to maximize profits, since they will inevitably make mistakes, and for firms that are not. Society would be much worse off, since it would put firms in a straight jacket that would limit their ability to meet the needs of their workers, customers, and investors, and it would dramatically raise the costs of risk taking.

Some corporate chiefs may believe they have a duty to maximize shareholder value, but this belief comes from the views of shareholders (that is, all of us) and not the law. Insofar as corporations are too interested in profits, to paraphrase Shakespeare, the fault Senator Franken lies not in the law but in ourselves.

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27 responses to The shareholder wealth maximization myth

Isnt this a case of conflating the standard of care with the standard of review? The fact that in the case of corporate directors there is a gulf between corporate duties and what is required to demonstrate their breach does not negate the fact that, while rather practically unenforceable in fact, the care standard, including the obligation to act in the best interests of the corporation, including its shareholderss, exists.

Todd, the quote is close, but I think contains some ambiguity. “While the duty to maximize shareholder value may be a useful shorthand for a corporate manager to think about how to act on a day to day basis, this is not legally required or enforceable.”

I agree that any duty to maximize shareholder value is not legally enforceable. To the extent hat you meant “legally required” and “legally enforceable” to be the same thing, then I agree with that too. But my very premise was that there can be things that are legally required (in some sense of that word) but which are not judicially enforceable, such as Congress’s duty to provide a republican form of government. That is a philosophical debate.

Todd, where I think this gets interesting is when corporations make decisions that are clearly in the short term but not long term interest of the shareholders. For example, imagine a firmthat settled certain claims for a recovery of about $20 million, when it believes that it would have collected over $100 million by waiting another 2-3 quarters, all in order to get an extra penny on the share price and thereby meet the earnings targets it had forecast. In effect, applying an extreme discount rate to it’s expected future cash flows.

Seems like a bad decision. But doesn’t seem like bjr territory, unless there’s an argument that propping up near-term share price was self dealing or some kind of securities violation.

The law says directors owe a duty of loyalty and care to shareholders as well as the corporation.

What could this duty possibly mean, a duty to a sea of anonymous shareholders, including people who will never interact with the corporation in any other way and live in foreign countries, pension funds, and sovereign wealth funds?

Your tortured distinction that they supposedly owe only a duty not to help themselves rather than to help the shareholders breaks down here. If that were the only duty, the duty could not be to the shareholders, since they shareholders really can’t care about that. Their only interest as a group is the value of the stock. If they are owed a duty, the duty is to act in ways that help and do not hurt their financial interest. The duty of care has been expressed as how a prudent person would act in the management of their own property. The duty of loyalty is undivided and total loyalty to their interest. Their interest is to make money.

I understand your temptation to come up with reasons why it doesn’t have to be this way, but this really is the way the law reads. How it is practical to enforce is another matter, hence the BJR, but in terms of duties owed, if courts had perfect information, directors could be sued for helping non-shareholders at the expense of shareholders.

In reality, this is usually impractical because corporate contributions to the public weal are helpful for marketing and political lobbying. Nothing else to see here, no crazy theories that management is free to stiff shareholders to help out useless war criminal employees or endangered rats that are so widely hated that helping them would not benefit the shareholders in any way.

We may be at the point of diminishing returns to this dialogue, which I’ve enjoyed. Let me quote from my post:

“While the duty to maximize shareholder value may be a useful shorthand for a corporate manager to think about how to act on a day to day basis, this is not legally required or enforceable. . . . .Some corporate chiefs may believe they have a duty to maximize shareholder value, but this belief comes from the views of shareholders (that is, all of us) and not the law. Insofar as corporations are too interested in profits, to paraphrase Shakespeare, the fault Senator Franken lies not in the law but in ourselves.”

I stand by this, which is what you are saying too I think.

As for what the law would be in the case where there was more pressure from shareholders, employees, workers, etc. to maximize things other than profits, I’m not willing to guess, but I’m a lot less confident than you are. Wouldn’t it be strange if corporate stakeholders were more interested in forms of utility that weren’t money, and the courts forced them to care more about money. Strange, no?

For the record, if I were running a company, I would care about the bottom line, since it would be not only the best day-to-day guide for decisions, but also the best approximation we have for the net social value of all transactions. Knowing what I know, however, I would do this for reasons other than because the law made me do it.

Todd, to the extent that your post is only saying that “corporations are not practically prevented from acting in ways that do things other than maximize profits,” we agree. I think “myth” is a bit strong to convey that sentiment, but that is neither here nor there.

One quibble that goes to answer Lyman’s point, however, is that corporations are only “not practically prevented” by courts from acting contrary to shareholder interests. They are practically prevented from doing so by other mechanisms of shareholder control–at least to some extent. And it is the very height of legal formalism to draw some neat separation between “law” and “social/business norm” that Lyman does in her last post. It is inconceivable that the business judgment rule would be so deferential, I submit, without the existence of other mechanisms of shareholder control over directors.

Referring to Steve Bainbridge’s blog as one writer did, Steve’s good faith theory and hypo don’t take him where he wants to go. First, as always, the conversation is dominated by Delaware law, but over half the states have statutes that specifically permit director consideration of non-shareholders. Second, even in Delaware, Revlon is a very special case, especially given its tight cabining by Ryan v. Lyondell in 2009. Third, Steve stacks the deck by positing in his hypo that both the “corporation” and it stockholders are harmed, but the distinction between the two is often very significant and not a matter of semantics or legal formalism, much as Steve might wish the corporation( a legal “person,” like it or not) to = the stockholders. Corporate statutes mandate that directors are to direct the affairs of the “corporation” not stockholders, etc. So, yes, good faith requires no deliberate disregarding of the corporation’s interests but does not, outside Revlon to date, foreclose a deliberate disregarding of stockholder interests, though few but Henry Ford or Mr. Wrigley would so state(and that is precisely because the social/business norm–not the law–of shareholder primacy may well be stronger today than in their day).

Yes, Bamdale, a little perjury goes a long way. Any decision can be justified in the way you suggest, especially given the information disadvantage courts have. In part, this is why Ford “lost.” He bragged about doing good instead of making money because he didn’t want people to think he was greedy. But today, Ford wins, simply by saying that what he was doing was in the interests of the corporation. So I think we ultimately agree. There is something about serving shareholder interests, but it isn’t practically enforceable. So, going back to the Franken quote, the point stands: corporations are not practically prevented from acting in ways that do things other than maximize profits.

Weighing in one more time, I agree with Martin, TJ, and the Professor that the BJR immunizes certain decisions. My point is that the BJR only applies if the decision is articulated as a reasonable attempt to benefit the corporation itself. I think a director/officer that comes into court and admits he pursued community goals against corporate interests is inviting a directed judgment in favor of the corporation. It would seem that the BJR has no meaning at all if it is merely a re-articulation of the fiduciary duties. The reasonableness prong of the BJR, albeit highly deferential, measures the officer/director’s subjective decision making, not unlike a fraud analysis.

One other observation: I think academic research and writing is useful for many things. But citing legal articles rarely helps a client prevail in trial courts. Most state trial judges – New York being one exception; Illinois being no exception at all – are not interested in those analyses. I would like to reveal how I know that, but my duty to protect my clients outweighs the community interests I can promote by revealing them here. I’m sure I can articulate something, but as many practicing and non-practicing attorneys know, the more you indulge, the harder it is to hide behind the BJR. Thanks again for the discussion.

I read the essay, and it is good. But it is good partly because it acknowledges contrary authority, in that various cases do on occasion suggest a duty to maximize long-run shareholder wealth.

Our dispute is one of theory, not empirics. On the empirics, I have no disagreement with your position that courts will shield directors from just about any conceivable action under the business judgment rule. On the empirics, it is as Stout says, “In the rare event such a decision is challenged on the grounds the directors failed to look after shareholder interests, courts shield directors from liability under the ‘business judgment rule’ so long as any plausible connection can be made between the directors’ decision and some possible future benefit, however intangible and unlikely, to shareholders. If the directors lack the imagination to offer such a “long-run” rationalization for their decision, courts will invent one.”

But from this empirical observation, two interpretations arise. And I think the fact that courts still need to “invent” a shareholder benefit shows that there is a duty to act for shareholder benefit above all else. The duty is weak, and its enforcement practically non-existent; but on the fundamental conceptual question of whether there is a duty at all, the very fact that courts still feel the need to invent a shareholder justification is very telling.

Thanks for the link to the Stout essay. Although it is no longer online, I can remember as venerable an authority as Judge Posner citing Dodge v. Ford for the proposition that managers had a duty to maximize shareholder wealth in a comment on the Creative Capitalism blog a few years ago.

But maybe this really is a case of the decision rules and the conduct rules deviating. What good is it if only corporate law scholars know that Dodge v. Ford is a dead letter?

So law professors at Illinois, UCLA, Wash U, and Chicago (so far), including the author of the leading text and hornbook on the subject (that is, Bainbridge at UCLA; see his post on my post at his blog) disagree with you, but you persist. That is your right. But why don’t you put your money where your mouth is? Bring a case against a firm, oh, just pick any of the Fortune 500, who gives to charity or voluntarily acts in ways that are not obviously (to you) profit maximizing. You won’t have trouble finding one. We will then see if the court requires the directors to “assert a plausible business benefit.” (Here’s a hint: you are going to lose.)

As for Dodge, it is often cited for the norm of shareholder wealth maximization, but it is one case, a hundred years old, and it doesn’t even stand for what you think it stands for. Two recent essays on this case, one by me and one by Lynn Stout at UCLA, confirm this in detail. Go read her great essay, here: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1013744. In case you don’t have time, here is the abstract:

“Among non-experts, conventional wisdom holds that corporate law requires boards of directors to maximize shareholder wealth. This common but mistaken belief is almost invariably supported by reference to the Michigan Supreme Court’s 1919 opinion in Dodge v. Ford Motor Co.

This Essay argues that Dodge v. Ford is bad law, at least when cited for the proposition that maximizing shareholder wealth is the proper corporate purpose. As a positive matter, U.S. corporate law does not and never has imposed a legal obligation on directors to maximize shareholder wealth. From a normative perspective, options theory, team production theory, the problem of external costs, and differences in shareholder interests all suggest why a rule of shareholder wealth maximization would be bad policy and lead to inefficient results.

Courts accordingly treat Dodge v. Ford as a dead letter. (In the past three decades the Delaware courts have cited the case only once, and then on controlling shareholders’ duties to minority shareholders). Nevertheless, legal scholars continue to teach and cite it. This Essay suggests that Dodge v. Ford has achieved a privileged position in the legal canon not because it accurately captures the law – it does not – or because it provides good normative guidance – it does not – but because it serves professors’ need for a simple answer to the question, What do corporations do? Simplicity is not a virtue when it leads to misunderstanding, however. Law professors should mend their collective ways, and stop teaching Dodge v. Ford as anything more than an example of how courts can go astray.”

Lyman, Steve Bainbridge has some quotes over on his blog that I think show a legal duty to maximize shareholder wealth. As Bainbridge sums Revlon: “‘Because the business judgment rule did not apply, the directors “breached their primary duty of loyalty’ by failing to obtain ‘the highest price for the benefit of the stockholders.'”

I take Todd’s point that the BJR gives directors tremendous flexibility to deviate, so as a practical matter the underlying duty is weak to the point of non-existence (which is also why it is so rarely articulated in opinions). But, as we seem to all agree, the question is whether there is an underlying duty, and I think a better description is that there is a duty to maximize shareholder wealth with tremendous deference to managers on how to do so, rather than Todd’s formulation that there is no such duty at all.

Well, Professor, I respect and appreciate your response, but we will have to agree to disagree. I just read the Wrigley case and it seems to confirm my view that the law considers the officer’s motives when determining whether he has violated his fiduciary duties. The Wrigley court actually cited a case, Dodge v. Ford, also cited by a commenter above, which could not have been clearer about the application of this standard. There is no mistaking the following two quotes from the Ford case: 1. “Henry Ford’s philanthropic motives did not permit him to set Ford Motor Company dividend policies to benefit public at expense of shareholders.”; and 2. “The discretion of directors is to be exercised in the choice of means to attain that end, and does not extend to a change in the end itself, to the reduction of profits, or to the nondistribution of profits among stockholders in order to devote them to other purposes.”

I don’t want to argue the point ad naseam because I don’t think it is as controversial as your blog entry would suggest – notwithstanding the political grandstanding of Franken or Friedman. However, I would close with the observation that if the business judgment rule has any meaning at all, it has to entail more than an re-analysis of the duty of cary/loyalty. Indeed, the BJR has a prong for reasonableness. The reasonableness prong goes to whether the officer’s action is reasonable in light of his duties. I would submit, and I think the Ford case stands for this proposition, that it is per se unreasonable for an officer to pursue a community goal at the expense of shareholder value. The BJR doesn’t help the officer in that event and might have no application if he cannot assert a plausible business benefit that could arise from the act. Thanks.

Re comment by Bamdale: This is not the law. Respectfully, you are wrong. The business judgment rule insulates board decisions of the kind you suggest, so long as they are informed (duty of care) and not self dealing (duty of loyalty). To take just one example, take a look at Shlensky v. Wrigley, where the court held allegations that the owner of the Cubs wasn’t following the profit-maximizing strategy by refusing to install lights for night games was not actionable, even though the owner said he was driven in part by concerns about the impact on neighbors. To be sure, one can argue that these considerations, and others like them, are germane to the long-term value of the brand of the team, but the court didn’t make these inquiries. They are not issues courts consider. Absent a grossly negligent failure of process or some conflict of interest, there is no judicial review of these kinds of board decisions. Period, end of story.

Professor: I strongly disagree with your analysis. A corporate officer who intentionally pursues a “community benefit” at the expense of shareholder interests has violated the duty of care if the decision actually results in a tangible loss to the shareholders. The business judgment rule only serves as a defense if the officer’s action can be construed reasonably as an attempt to increase short-term or long-term gains for the corporation. The BJR doesn’t countenance taking a position that will likely harm the corporation simply because the officer can find some constituency (environmental lobby, organized labor, etc) that favors that position. In fact, if the officer becomes deeply entangled in helping communities (that is, non-shareholders) pursue interests, he has probably run afoul of the duty of loyalty doctrine also.

Communities and environments must pursue their own goals by starting their own corporations and competing. Permitting corporate officers to forsake individualistic shareholder interests to pursue collectivistic societal interests could cause the breakdown of time-tested, role-specific modes of corporate governance.

Lyman and I don’t agree about much, but on this we are in perfect alignment. That should tell the doubters something.

There is something to the comments saying the argument avoids the overwhelming (non-legal) background norm. That was my point with the Shakespeare quote. If CEOs feel pressure to maximize profits at the expense of all else, it comes from us, the investors, not the law. As for the facts, it simply isn’t true that non-profit-maximizing firms are all ground under by the market. There is a multi-billion investment industry targeting “socially responsible” companies, who, by definition, are leaving money on the table. In addition, hundreds of firms are voluntarily reducing green-house-gas emissions beyond what is required by the law. Sure, one can tell stories about how this might help the bottom line, but more likely, it helps managers meet the diverse needs of customers, investors, and workers in ways that are hard to know or enforce with law. It simply isn’t true that if Ford decided to dramatically raise their fleet MPG, they could face a lawsuit (as the Senator suggests). Ford’s managers don’t have to justify that decision to the stockholders in court — they do in the market, but the market demands more than just profits. The fair-trade movement is just another example of this. Finally, companies are routinely permitted to donate anonymously to charity. This cannot be reconciled with a shareholder wealth maximization norm.

The question is not whether duties are owed; they are owed, in Delaware, to the “corporation and its stockholders.” But a duty to do what? I would ask any of the prior commenters to point to a law–anywhere in the US–that states that a board of directors has a legal duty to maximize shareholder wealth. Again, the issue is not the BJR; it is the absence of an underlying duty itself.

Senator Al “the Felon” Franken (as he was elected by illegal votes from felons) needs to keep his trap shut and stop lying to the public. There used to be an old saying “How do you know when a politican is lying? His lips are moving.” The brainwashed fools on the left have forgotten this age old truth, and the result is the mess we are in today. It should be a crime for Senators to misrepresent the law to the public for political gain. If a lay person does this, it is considered the unauthorized practice of law. If a politican does this, he gets votes and applause. Throw the book at these fools and kick them out of Washington.

Todd, this is not my area, but it seems that you are confusing the right (or duty) and its judicial enforceability. It is true that under the business judgment rule, managers get a lot, a lot, a lot of leeway. But to say that they get leeway means they are deviating from an ideal or goal — and it seems that the ideal and goal is still the maximization of shareholder wealth.

We have all sorts of legal duties that are imperfectly enforced by courts. Congress has a legal duty to ensure that every state has a republican form of government. Pretty sure that courts will defer to Congress’s “business judgment” on how to go about meeting that duty. Doesn’t mean the duty doesn’t exist.

And what is the “interest of the corporation” (duty of loyalty) if not the interest of the shareholders who have the right to its profits, pray tell?
Outside the zone of insolvency, where the fiduciary duties shift to creditors, courts and lawyers alike in the United States hold that these duties are owed to the shareholders. How could you fail to address this fact?
The rule is that the directors owe the shareholders these duties outside the zone of insolvency derivatively through the corporation. This forms the foundation for the derivative lawsuit, among other things. Our entire corporate legal system is based on this fact; to deny it is just silly.
The management-centric view holds that shareholders have to be protected from their short-termism, and that is why managers should be able to keep shareholders from deciding certain things. The shareholder-centric view disagrees. Both views agree that the shareholders are protected by directors fiduciary duties to the corporation.

Aren’t you being a bit too literal here? It is true that there is not a legal prohibition, applicable to every corporate decision, on actions that do not maximize the profits of the company. But I doubt Franken or Friedman think they are articulating black letter Delaware corporate law.

Instead the unavoidability of the profit-motive is a structural constraint of any competitive economy. Those firms that seek to protect the environment instead of maximize profits will eventually be displaced by firms with managers that are less charitable (with shareholders money).
Profit maximization is not a theory of psychology that seeks to describe managers’ inner dialogues. See Friedman (1953). I’m not sure if the business judgment rule really undermines this perspective.

What about the Dodge v. Ford line of cases? Seems like Franken might have had these cases in mind.

But I take your point that there may not be a big difference in conduct rules because (as you suggest) the business judgment rule is so loose as a decision rule, and seldom are managers seeking to (more or less) explicitly do philanthropy. One does see quite a range of corporate strategy reflected in annual reports and prospectuses. The Google prospectus is one illustration of how far we’ve come since Dodge v. Ford. There’s some quirky stuff in there, and I sometimes wonder how many of the institutional funds on wall street have read it. Longer term, I expect to see more and more quasi-governmental or quasi-philanthropic charters.

True enough, Todd, and a point I myself have made in several pieces, but the “hold” of the shareholder wealth maximization norm(and it is an especially strong and unexamined social norm) is so deeply-embedded in our corporate and larger culture that it cannot readily be swept away by a true understanding of the law(which you provided). To displace it will require a change in those venues that constantly reaffirm and bolster the norm, not the least of which are B schools and perhaps a significant number of law schools. Of course, there are constraints such as markets and shareholder voting rights also at play but the real work for those who do not like the norm–of course one can believe the norm is not legally-mandated and still like it–is to work for change in non-law venues, a long slog but the proper one once the law is rightly understood. You are correct to point out that misunderstandings abound on left and right, but the practical upshot of a correct understanding of this matter are quite different for the two ends of the ideological spectrum.